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Nguyen The Cam Hoan Le Tung Bach HB Group-Cohort 4 VEMBA HCM

Bus 633 Case Study Finance Management Report 2

Case 8: Stephenson Real Estate Recapitalization.


I. Case summary and assumptions Stephenson Real Estate Company is a 25 years old real estate development and management company. The company shows continuous profit within the past 18 years. Due to past duress with debt management, the company s CEO chooses to finance his company with equity only. Currently, the company has 15 million shares outstanding and the last traded price was USD 34.50 per share. The company has virtually no debt. The current cost of capital of the company is 12.5%. The company is subject to 40% corporation tax rate. The company is now preparing for a new project which consists of purchasing a tract of land in the southeastern USA for USD 95 million. The land then will be leased to tenant farmer. Consequently, the lease increases the earnings of Stephenson by USD 23 million on pre-tax basis. The CFO thinks that the company can finance this project using debt structure. As a result, she thinks that an issue of bond with 8% of coupon rate is reasonable. She also feels that a capital structure of 70% of equity and 30% of debt is the most profitable for the company. The debt shouldn t be more than 30% because it will make the bond carrying lower rating and much higher coupon rate. The aims of the team are to evaluate the CFO proposal and helping the CFO with data calculation so she has enough information to make an informed decision for this project. In the following chapter, the summary of data and assumption will be presented. Also, the processing and calculation data prior to the calculation of capital structure will also be addressed in this part. II. Data Collection and Fact Findings According to the summary description above, below are the numbers of Stephenson Real Estate Capitalization: Stephenson Real Estate Recapitalization Data Outstanding Share Stock Price Mkt Cap Rwacc Expected post-tax earning 15,000,000 34.50 517,500,000 12.5% 64,687,500

With a number of outstanding shares of 15 million shares and a stock price of USD 34.50, the market capitalization of Stephenson is around USD 517.5 million. With the cost of capital is around 12.5% annual, the expected-post tax earnings of the company should be around USD 64.69 million. Move on to the project description, according to above data, the summary of the new project according to the data provided by Stephenson: New Project of Stephenson Real Estate Data Land cost 95,000,000 Incresead in Earning pre-tax 23,000,000 Incresead in Earning post-tax 13,800,000 Present Value of the Project 110,400,000 Net Present Value of The Project 15,400,000 Coupon Rate of Bond 8% Debt/Debt+Eq 0% Eq/Debt+Eq 100% Tax rate 40% Total Post-tax expected 78,487,500 earnings

Current land cost values as USD 95 million and the Earning pre-tax will be increased by USD 23 million. The earning post-tax will be at USD 13.8 million. The total expected earnings will be increased up to USD 78.49 million. By applying the calculation of NPV on the project data, the present value of the project is USD 110.4 million. As a result the NPV of the project is around USD 15.4 million.

III. Cost of Capital Calculation 1. Cost of Equity Under the Capital Asset Pricing Model, the expected return on the stock can be interpreted as follow: Rs = Rf + *(Rm-Rf) Where Rs is the expected return, Rf is the risk-free rate, is the stock beta and (Rm-Rf) is the market risk premium. For the US market, the standard assumption is the market risk premium is around 7%. As

seen in the chapter two, the beta of dell is around 1.26 (36 months monthly return moving average period). For the risk free rate, based on the table 3 above, the team feels that it is acceptable to choose a risk free rate of 3%. The 3% risk free rate can reflects a longer period debt and prudently forecast the cost of equity for this case. Following are the result of the calculation: CAPM Model
Risk Free Rate Beta Market Risk Premium Expected Return (with Dell Beta) Expected Return (with Industry Weighted Market Cap Beta) Expected Return (with Industry Equally Weighted Beta) 3% 1.26 7.00% 11.82% 9.80% 10.44%

Table 4. Dell cost of Equity Result It proves that the cost of equity or the expected return of Dell is ranging from 9.80% to 11.82% depend on the beta in question. If the calculating is being made for Dell, then Dell cost of equity is 11.82%. Alternatively, this result must be reverted to Goff computing, as such two other CAPM outputs with the beta of industry (weighted average and equally average). The range of variation of the expected return is around 2% depend on the beta in used. With the weighted average beta, leading company in the industry such as Apple has a massive market cap. The beta of Apple is relatively and strangely slow which leads to the overall beta (weighted) of the industry is considerably slower comparing to Dell. With equally weighted, the beta show sign of improvements up to 1.06, thus increased the cost of equity to 10.44%. It is also noteworthy to point out that the competitors of Dell and/or Goff such as Sony, Toshiba, Samsung, Lenovo, Acer are being listed across Stock market in Asia, from Tokyo, Seoul to Taiwan, Hong Kong. The way of calculating beta might be different on these floors comparing to US standard. Furthermore, these countries currency might be appreciated strongly against the US Dollar which will create more fluctuation on their stock market as well. In the second section of this writing, team will attack the valuation of the cost of debt of Dell. 2. Cost of Debt As mentioned in the chapter I, Goff computing has no debt yet. They finance their project using their own profit. In this case Dell sot of debt will be calculated as a reference for Goff Computing. Based on the table 2, here is the cost of Debt structure for Dell: Dell Cost of Debt Calculation

Bond Symbol

Coupon

Price

Yield

Book Value (in m USD)


400 600 500 500 300 400 700 400 500 600 400 300 400 300 6300

Book Value Yield (in m USD)


2.84 4.55 4.23 0.00 3.69 4.60 11.26 5.21 13.92 18.10 13.60 14.93 19.72 14.91 131.55

% of Total Book Value


0.05% 0.07% 0.07% 0.00% 0.06% 0.07% 0.18% 0.08% 0.22% 0.29% 0.22% 0.24% 0.31% 0.24% 2.09%

Market Value (in m USD)


404.54 630.00 504.57 501.16 305.72 439.82 717.15 429.44 581.86 713.36 438.46 370.41 491.82 319.50 6847.80

Market Value Yield (in m USD)


2.9 4.8 4.3 3.8 5.1 11.5 5.6 16.2 21.5 14.9 18.4 24.3 15.9 149

% of Total Market Value


0.04% 0.07% 0.06% 0.00% 0.05% 0.07% 0.17% 0.08% 0.24% 0.31% 0.22% 0.27% 0.35% 0.23% 2.18%

DELL.GJ DELL.GF DELL.GL DELL.GP DELL.GO DELL.GI DELL.GM DELL.GQ DELL.GG DELL.GK DELL.GR DELL.GB DELL.GH DELL.GN Total

3.38% 4.70% 1.40% 5.63% 2.10% 5.63% 2.30% 3.10% 5.65% 5.88% 4.63% 7.10% 6.50% 5.40%

101.14 105.00 100.91 100.23 101.91 109.96 102.45 107.36 116.37 118.89 109.62 123.47 122.95 106.50

0.71% 0.76% 0.85% 0.00% 1.23% 1.15% 1.61% 1.30% 2.78% 3.02% 3.40% 4.98% 4.93% 4.97% 2.26%

The calculation above showed that, the range of cost of debt varies from 2.09% to 2.26%. The yield can be calculated from simple averaging to weight against the book value of long term debt or market value of the long term debt. The different between book value and market value is around 0.09%. It is also noticeable that Dell has more than USD 1.8 billion in short-term loan. It is possible to including it into the calculation cost of debt. However, these short term loan have very low interest rate (0.33%) and usually take around 30-90 days to paid off. This interest rate will lower the overall cost of Debt of Dell and might lead to an unclear estimation cost of Debt. It also appears that the Dell bond increased almost 9% in value and the yield increased by 13%. As a result, it seems that company like Dell is now moving towards a debt financing structure due to the fact that the cost of debt is considerably low. 3. The Cost of Capital The cost of capital (Rwacc) can be estimated using the below formula:

Where B/S is the debt-equity ratio, Rs is the Cost of Equity, Rb is the cost of Debt and tc is the corporation tax rate. Following are the result:

Dell Rwacc calculation


Total Long Term Debt Total Equity Total Company Value 6847.8 28420 35268

% of Debt % of Equity Corporation Tax Rate Rwacc (Dell beta CAPM) Rwacc (Industry Market Cap weighted beta CAPM) Rwacc (Industry Equally weighted beta CAPM)

19.42% 80.58% 35% 9.81% 8.18% 8.70%

The team chose to use the market value of the bond for presenting Dell long term debt and choose the highest yield for cost of debt. Such approach can be considered prudent for the case of Dell. The result showed that the range of Dell Rwacc is running from 8.18% to 9.81%. When using the book value as long term debt, the rates increase almost one percent and ranges from 8.81% to 9.94%. As we all known that the smaller the size of the company is, the more expensive funding company will get. Dell cost of capital is from 9 to 10%. CGI is at a much smaller size compare to Dell, the cost of capital for CGI is likely to be added from 1% to 3% interest premium compare to Dell. It seems that the minimum cost of capital of CGI will be likely around 12% to 12.5%. III. Conclusion In conclusion, due to the lack of track record from CGI, Dell is being employed to estimate the cost of capital for CGI. However, there are several drawbacks to this approach. First of all, Dell and CGI do not have the same operating model. While Dell is custom-made online and has no store, CGI sells its good in-store. Dell does not spend their money in open store. Secondly, the site of Dell and CGI is considerably different. Dell is global corporation while CGI is a regional privately owned company. The cost of capital of CGI will be quite higher than Dell. In addition, the premium which CGI has to pay cannot be forecasted with ease. It is better to find another company which operating in the same business model like CGI for calculating the cost of capital. Finally, there is company like CompUSA which has an operation model like CGI but unfortunately being bought by TigerDirect (another company operate like Dell). For the Goff computing, there are a few ideas through this analysis which worth to consider. The cost of financing through equity is almost 5 times higher than financing through debt. Since the company is privately owned by the family, financing through long-term debt is worth to try. Second lesson is that through the competitor lists, most of the top company is selling heavily online and focus on ecommerce. Perhaps Goff computing might like to change its operation model to adapt and survive.